Analysis & Opinion

BERLIN (Reuters) - Following a now-familiar script, Europe again averted disaster in its debt crisis when German lawmakers rallied behind Chancellor Angela Merkel to approve a stronger euro zone bailout fund on Thursday.

But bigger challenges loom for the euro zone now. Financial markets are already anticipating a likely Greek default and demanding more far-reaching measures to prevent the crisis that began in Athens from spreading far beyond Europe and its banks.

The Bundestag (lower house) overwhelmingly approved new powers for the 440-billion-euro EFSF fund to make precautionary loans, help recapitalize banks and buy distressed countries' bonds in the secondary market.

Despite a rebellion by 15 backbench Euroskeptics, Merkel won 315 votes from her own center-right coalition, enough to avoid the humiliation of having to rely on the opposition Social Democrats and Greens to pass the plan.

"The result of the vote is a strong signal for Europe. The broad majority in parliament clearly shows that Germany is committed to the euro and to protecting our currency," said Hermann Groehe, general secretary of her Christian Democratic party.

The measure was part of a July 21 agreement by euro zone leaders meant to solve the crisis by providing a second bailout for debt-stricken Greece, partly funded by private sector bondholders, and providing more firepower to prevent contagion engulfing bigger EU economies Spain and Italy.

But that deal failed to stop Italian and Spanish borrowing costs soaring, forcing the European Central Bank to intervene in August to buy their bonds, and may yet unravel in Greece, which has fallen behind again on its deficit reduction targets, pushing it closer to default.

"There is a growing realization, even among the more reticent, that the July 21 package is yesterday's war, and we need to go further," a senior EU official said, speaking on condition of anonymity.

The euro and European shares ticked up and safe-haven German bonds fell after the closely-watched vote in Europe's pivotal power, where public opposition to further bailouts is rife.

But analysts said financial markets and outside powers still want a more comprehensive response from European Union policymakers to the debt crisis.

U.S. President Barack Obama kept up a drum beat of criticism of the EU's crisis management, saying on Wednesday: "In Europe, we haven't seen them deal with their financial system and banking system as effectively as they need to.

EU officials are already working on ways of leveraging up the rescue fund, but kept those legally and politically fraught options under wraps ahead of the German vote to avoid antagonizing waverers in the Bundestag.

Underscoring the sensitivity, German Economy Minister Philipp Roesler, leader of the liberal Free Democrats, junior partners in Merkel's coalition, said on a visit to Brussels after the vote that Berlin does not want to leverage the bailout fund.

The European Commission welcomed German approval of the EFSF boost and said it was confident the ratification process would be complete throughout the 17-nation currency area by mid-October.

Elsewhere in Europe, there was a sense of relief. French President Nicolas Sarkozy telephoned Merkel to congratulate her and invited Greek Prime Minister George Papandreou to talks in Paris on Friday to discuss Greece's precarious debt situation. Papandreou met Merkel in Berlin on Tuesday.

Cyprus also back the EFSF's new powers on Thursday, taking the number of states that have approved to 12. Of the remainder only Slovakia's endorsement looks politically tricky.

PAIN IN SPAIN, ITALY

Despite the German vote, developments in Spain and Italy highlighted the stark challenges still facing the euro zone in coping with the sovereign debt crisis.

Spain's ruling Socialists abruptly shelved plans to boost public coffers by selling part of the state lottery for up to 9 billion euros ($12 billion), in the face of tough market conditions, political opposition and banks' funding concerns.

The backtracking, a day before book building was supposed to begin on the public offering of 30 percent of Loterias, was a blow a few weeks before a November 20 election, which opinion polls show the center-right People's Party sweeping.

Banks involved in the sale, Santander and BBVA, saw the Loterias flotation as a direct rival to their efforts to bolster their capital by enticing Spaniards to withdraw deposits to invest in lottery shares.

Italy meanwhile had to pay the highest yield on a 10-year bond since the introduction of the euro in 1999 at an auction on Thursday, the first long-term sale since Standard & Poor's cut the country's sovereign credit rating.

Italy sold 7.86 billion euros of long-term bonds, moving closer to an overall issuance target of 430 billion euros for the year, but the 10-year yield rose to 5.86 percent at the auction, up from 5.22 percent a month ago.

"That's eye-watering yield levels," said David Schnautz, a rate strategist at Commerzbank.

In Athens, senior officials of the troika of European Commission, ECB and International Monetary Fund resumed talks aimed at checking that Greece has met the terms of its bailout program after adopting new austerity measures. The Greek Finance Ministry called the climate "positive and creative".

The government will run out of money to pay salaries and pensions in October unless it receives the next 8 billion euro installment of emergency loans. It pushed an unpopular new property tax through parliament this week despite public anger.

Anti-austerity protesters blocked the entrances to several ministries before the start of the talks.

"The occupations are carried out today when the troika returns to our country and as we face new barbaric measures which were decided and are being decided for further wage reductions ... new tax hikes and mass layoffs," public sector ADEDY said in a statement.